…the CDS [credit default swap] positions of large US banks during 2001–06 grew at an average compounding annual rate of over 80%.

That’s from a very good paper by Darrell Duffie.  There is more:

Of all 5,700 banks reporting to the US Federal Reserve System, however, only about 40 showed CDS trading activity and three banks – JP Morgan Chase, Citigroup and Bank of America – accounted for most of that activity.

The net transfer of credit risk away from banks is estimated to account for 30 percent of the market.  Furthermore a bank may go short on the credit risk of a company it is lending to.  A CDS is then a substitute for selling or securitizing the loan.  If you think securitization is overdone, CDS has this benefit namely that it is a potential substitute. 

A bank also can short the credit risk of a company by dealing in its bonds and other securities.  But these other security markets are regulated and replete with restrictions on short sales and the like.  The CDS markets don’t have comparable restrictions.  You can think of the CDS market as, in part, an attempt to circumvent regulations and trading costs in other securities markets.

Here is the single best paper on CDS that I know.  Enjoy.

My alternative is to encourage new lending by lowering capital
requirements at the margin. Tell banks that loans issued after
September 1, 2009, require half the capital of similar loans issued
before September 1. Some banks are in such bad shape that even with
those lower capital standards they will not be able to make new loans.
Fine. You don’t want those banks to grow. But other banks have room to
grow, and you want them to grow more than they would under the existing
regulations.

As with changing accounting rules, lowering capital requirements
ultimately exposes the government funds that insure banks to more risk.
That is the flaw in the idea. However, there has to be some risk
exposure to tax payers for any policy that encourages bank lending.

Here is more.  One question I have is how to calculate the existing capital for the very worst, most insolvent, and most corrupt banks.  You don’t want them making loans to their uncles, so to speak.  Would requiring 1/2 capital discriminate usefully against such banks or would it in fact select for their relative expansion?  Or do we have this problem in any case?

Via Brad DeLong, here is a summary of the Dodd plan.  It sounds like an improvement over the Paulson plan.

Read his latest post, which outlines many key but usually unstated assumptions behind monetary theory and policy.  It is one of the most instructive econ posts to appear in some time. 

That said, on the policy issue I think one of Krugman’s earlier posts (I can’t find it) is closer to the mark.  With or without a liquidity trap, monetary policy can’t fix negative real shocks and — here is now the earlier Krugman — monetary policy can’t make insolvent (or potentially insolvent) banks whole.  That’s my take on why the Fed is relatively powerless, not because of a liquidity trap.  If you believe, as a Keynesian would, that insufficient aggregate demand is the problem in the first place, you will be relatively worried about liquidity traps.  If you believe, as a neo-Austrian would, that malinvestments and coordination problems are the key issues, you will look toward other factors which limit the power of central banks to restore order. 

In my view sometimes the Keynesian perspective is relevant, but not so much today.  As the contraction of credit spreads through the Fed-regulated banking sector, however, and the broader money supply aggregates come under stronger negative pressure, the Keynesian perspective is likely to become more relevant.  That is in fact my major medium-term worry and we probably should be pessimistic in this regard.

There is a separate and very important liquidity issue about restoring the markets and valuations for bank loans, but this is not a liquidity issue in the sense of Keynes’s portfolio theory or the traditional liquidity trap.

Addendum: Brad DeLong adds comment.  Another way of putting my point is this: in the situations where a liquidity trap might be binding, there is usually some even worse constraint which is more binding, thereby making the potential liquidity trap not so much a problem at the relevant margin.

Be wary when you hear talk of "derivatives" without further qualification.  They fall into three quite distinct categories: exchange-traded, over the counter (OTC), and swaps.  Here is the best overall paper I know on that division.  Wikipedia is useful as well.

I’ll cover swaps in a separate post soon, so for now let’s set those aside.

Exchange-traded derivatives include the instruments traded at the Chicago Mercantile Exchange and The New York Stock Exchange.  Their regulation has overall gone well and no one serious has alleged that they are responsible for our current financial problems.  That said, a single regulator is preferable to our current dual SEC-CFTC structure.

Most but not all OTC derivatives are interest rate derivatives.  Equity derivatives fit this category as well and so do credit default swaps (even though they are called "swaps" they do not here fit into the swaps category). 

These instruments are OTC because no clearinghouse in the middle guarantees the deal.  That means more credit risk and that no single middleman is tracking net positions on a more or less real time basis.  Ideally we would like to make OTC derivatives more like exchange-traded derivatives and we should consider regulation toward that end.  (Do note that private swaps regulators have already done quite a bit to
clear up the issue of hanging and unconfirmed transactions.)  At the margin the social benefits of such homogenization are higher than what the private swaps regulators will bring on their own accord.  In essence homogenization and trading through a clearinghouse limits the leverage issue to a single, easily-regulated institution and therefore it limits the problem of counterparty risk.

The cost of such additional regulation will be higher transactions costs for the trades themselves and also greater contract homogeneity, which is a requirement for exchange trading, netting, and clearing.  We need to make this move wisely and carefully, otherwise OTC derivatives could move to even wilder and less well regulated markets.  Simply trying to shut down the OTC markets, even if that were the economically ideal vision (unlikely), would in terms of risk prove counterproductive.  But the strong market positions of New York and London do make some effective regulatory action possible for OTC derivatives, especially if done in concert.

The lack of sufficient offset and netting and the inefficient spread of counterparty risk across a large number of institutions is an important issue behind current crises and it does not receive enough attention in most blogosphere discussions.

How about Europe?  The 2006 Markets in Financial Instruments Directive extends traditional European financial regulation to OTC derivatives.  Here is one source: "MiFID expands the definitions of financial instruments to include other frequently-traded instruments, including contracts for difference (CFDs) and other types of derivatives such as credit, commodity, weather and freight derivatives."  Here is one overview of MiFID. 

Implementation and enforcement is on a country-by-country basis and of course the UK is the big player.  Read pp.27-29 in the very first link above and you’ll see that overall the UK has a looser regulatory approach than does the United States, though not on every single matter.  For instance the UK is stricter on regulating hedge funds in OTC derivatives markets.

The more important point is that no country uses regulation of the derivatives market as its major line of defense against financial crises.  Rather countries regulate their financial institutions, their risk, their leverage, and their accounting directly, of course with more or less success.  Regulating the derivatives market, as opposed to regulating the institutions, and their possible participation in those markets, simply isn’t a very effective instrument.

To sum up: a) we should regulate OTC derivatives more, b) those regulations should aim toward establishing netting and well-capitalized clearinghouses, not micro-management of those markets, which would prove both impossible and counterproductive, and c) regulating OTC derivatives is only a weak substitute for regulating the institutions which trade in them.

The U.S. passed the Commodity Futures Modernization Act of 2000, which, among other things, limited the ability of the federal government to regulate OTC derivatives.  I’ll cover that Act in a separate post and yes I do think it should be amended.  But I’ll start by saying that most blogosphere critics of the act simply do not know or understand much of the above.

It’s always worth hearing from both sides, in this case Nadav Manham:

This [the purchases of the Paulson plan] has the effect of modestly increasing the stated book value of
these financial institutions.  More importantly, with the toxic waste
off the books, it improves the likelihood that an outside
investor–Treasury itself, a sovereign wealth fund, even our man in
Omaha–now feels able to value the enterprise.  Hold your nose and
admit it:  the relatively few franchises that manage the capital
raising and M&A activities of Corporate America are worth a lot.

3)
Said outside investors collectively have enough capital to recapitalize
the major Wall Street insitutions via injections of new equity.  Here
comes the tricky part: In exchange for their largesse, both the outside
investors and Treasury (e.g. via warrants struck at the same price as
the outside investor) must be allowed to invest on very favorable
terms.  In a perfect world existing equity holders and stock options
would be essentially wiped out, a la AIG.  In an even more perfect
world, existing debt holders (i.e. unsecured lenders to Morgan Stanley,
Merrill, etc.) would also take a big haircut, just as they usually do
when corporations declare bankruptcy. 

4)  Both liquidity and
solvency are restored, credit starts to flow again, and the downward
spiral of asset sales is prevented, allowing whatever pain will occur
to occur over time, and to be spread widely.

…as far as I can tell, the plan does not specify when Treasury
is obligated to buy toxic assets, nor does it prevent Treasury from
doing another AIG.  Conceivably it could wait until the maximum moment
of pain to get the best price possible for its assets.  Or it could
continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself.

There is more at the link.  A key assumption here is that jump-starting liquidity for bank assets is a big part of the cure; having the government dilute bank equity, as the Elmendorf plan suggests, does not on its own achieve this end.  I do find this a reasonable view, though as Paul Krugman points out it is unlikely that it is only a liquidity issue.  The implicit belief here is that resolving the liquidity issue is needed to make progress on the solvency issue.  Maybe.  But still I do not like the Paulson plan.  It reminds me of everything I dread about unchecked power and the administration’s score on this question is very, very bad.